1. 1 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs

2. 2 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs CHAPTER 10 Technology, Production, and Costs Technological change leads to new products and lower production costs. How do firms take costs into account when setting prices?

3. 3 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs 10.1Technology: An Economic Definition Define technology and give examples of technological change. 10.2The Short Run and the Long Run in Economics Distinguish between the economic short run and the economic long run. 10.3The Marginal Product of Labor and the Average Product of Labor Understand the relationship between the marginal product of labor and the average product of labor. 10.4 The Relationship between Short-Run Production and Short-Run Cost Explain and illustrate the relationship between marginal cost and average total cost. 10.5 Graphing Cost Curves Graph average total cost, average variable cost, average fixed cost, and marginal cost. 10.6 Costs in the Long Run Understand how firms use the long-run average cost curve in their planning Technology, Production, and Costs CHAPTER 10 Chapter Outline and Learning Objectives

4. 4 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs Technology: An Economic Definition Technology The processes a firm uses to turn inputs into outputs of goods and services. Technological change A change in the ability of a firm to produce a given level of output with a given quantity of inputs. Define technology and give examples of technological change. 10.1 LEARNING OBJECTIVE

5. 5 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs The Short Run and the Long Run in Economics Short run The period of time during which at least one of a firm’s inputs is fixed. Long run The period of time in which a firm can vary all its inputs, adopt new technology, and increase or decrease the size of its physical plant. Distinguish between the economic short run and the economic long run. 10.2 LEARNING OBJECTIVE

6. 6 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs The Short Run and the Long Run in Economics The Difference between Fixed Costs and Variable Costs Total cost The cost of all the inputs a firm uses in production. Variable costs Costs that change as output changes. Fixed costs Costs that remain constant as output changes. TC = FC + VC Total Cost = Fixed Cost + Variable Cost Distinguish between the economic short run and the economic long run. 10.2 LEARNING OBJECTIVE

7. 7 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs The Short Run and the Long Run in Economics Implicit Costs versus Explicit Costs Opportunity cost The highest- valued alternative that must be given up to engage in an activity. Explicit cost A cost that involves spending money. Implicit cost A nonmonetary opportunity cost. Distinguish between the economic short run and the economic long run. 10.2 LEARNING OBJECTIVE

8. 8 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs The Short Run and the Long Run in Economics Pizza dough, tomato sauce, and other ingredients$20,000 Wages48,000 Interest payments on loan to buy pizza ovens10,000 Electricity6,000 Lease payment for store24,000 Foregone salary30,000 Foregone interest3,000 Economic depreciation10,000 Total$151,000 Table 10-1 Jill Johnson’s Costs per Year Implicit Costs versus Explicit Costs Distinguish between the economic short run and the economic long run. 10.2 LEARNING OBJECTIVE

9. 9 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs The Short Run and the Long Run in Economics Table 10-2 Short-Run Production and Cost at Jill Johnson’s Restaurant The Production Function QUANTITY OF WORKERS QUANTITY OF PIZZA OVENS QUANTITY OF PIZZAS PER WEEK COST OF PIZZA OVENS (FIXED COST) COST OF WORKERS (VARIABLE COST) TOTAL COST OF PIZZAS PER WEEK COST PER PIZZA (AVERAGE TOTAL COST) 020$800$0$800— 122008006501,450$7.25 224508001,3002,1004.67 325508001,9502,7505.00 426008002,6003,4005.67 526258003,2504,0506.48 626408003,9004,7007.34 Distinguish between the economic short run and the economic long run. 10.2 LEARNING OBJECTIVE

10. 10 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs The Short Run and the Long Run in Economics The Production Function Production function The relationship between the inputs employed by a firm and the maximum output it can produce with those inputs. A First Look at the Relationship between Production and Cost Average total cost Total cost divided by the quantity of output produced. Distinguish between the economic short run and the economic long run. 10.2 LEARNING OBJECTIVE

11. 11 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs The Short Run and the Long Run in Economics FIGURE 10-1 Graphing Total Cost and Average Total Cost at Jill Johnson’s Restaurant A First Look at the Relationship between Production and Cost We can use the information from Table 10-2 to graph the relationship between the quantity of pizzas Jill produces and her total cost and average total cost. Panel (a) shows that total cost increases as the level of production increases. In panel (b), we see that the average total cost is roughly U- shaped: As production increases from low levels, average cost falls before rising at higher levels of production. Distinguish between the economic short run and the economic long run. 10.2 LEARNING OBJECTIVE

12. 12 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs The Marginal Product of Labor and the Average Product of Labor Marginal product of labor The additional output a firm produces as a result of hiring one more worker. QUANTITY OF WORKERS QUANTITY OF PIZZA OVENS QUANTITY OF PIZZAS MARGINALPRODUCT OF LABOR 020— 12200 22450250 32550100 4260050 5262525 6264015 Table 10-3 The Marginal Product of Labor at Jill Johnson’s Restaurant Understand the relationship between the marginal product of labor and the average product of labor. 10.3 LEARNING OBJECTIVE

13. 13 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs The Law of Diminishing Returns Law of diminishing returns The principle that, at some point, adding more of a variable input, such as labor, to the same amount of a fixed input, such as capital, will cause the marginal product of the variable input to decline. The Marginal Product of Labor and the Average Product of Labor Understand the relationship between the marginal product of labor and the average product of labor. 10.3 LEARNING OBJECTIVE

14. 14 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs Graphing Production FIGURE 10-2 Total Output and the Marginal Product of Labor The Marginal Product of Labor and the Average Product of Labor In panel (a), output increases as more workers are hired, but the increase in output does not occur at a constant rate. Each additional worker hired after the third worker causes production to increase by a smaller amount than did the hiring of the previous worker. In panel (b), the marginal product of labor is the additional output produced as a result of hiring one more worker. The marginal product of labor rises initially because of the effects of specialization and division of labor, and then it falls due to the effects of diminishing returns. Understand the relationship between the marginal product of labor and the average product of labor. 10.3 LEARNING OBJECTIVE

15. 15 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs Adam Smith’s Famous Account of the Division of Labor in a Pin Factory Making the Connection The gains from division of labor and specialization are as important to firms today as they were in the eighteenth century, when Adam Smith first discussed them. Understand the relationship between the marginal product of labor and the average product of labor. 10.3 LEARNING OBJECTIVE

16. 16 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs The Marginal Product of Labor and the Average Product of Labor The Relationship between Marginal and Average Product Average product of labor The total output produced by a firm divided by the quantity of workers. Understand the relationship between the marginal product of labor and the average product of labor. 10.3 LEARNING OBJECTIVE

17. 17 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs The Marginal Product of Labor and the Average Product of Labor An Example of Marginal and Average Values: College Grades FIGURE 10-3 Marginal and Average GPAs The relationship between marginal and average values for a variable can be illustrated using GPAs. We can calculate the GPA Paul earns in a particular semester (his “marginal GPA”), and we can calculate his cumulative GPA for all the semesters he has completed so far (his “average GPA”). Paul’s GPA is only 1.50 in the fall semester of his freshman year. In each following semester through the fall of his junior year, his GPA for the semester increases—raising his cumulative GPA. In Paul’s junior year, even though his semester GPA declines from fall to spring, his cumulative GPA rises. Only in the fall of his senior year, when his semester GPA drops below his cumulative GPA, does his cumulative GPA decline. Understand the relationship between the marginal product of labor and the average product of labor. 10.3 LEARNING OBJECTIVE

18. 18 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs The Relationship between Short-Run Production and Short-Run Cost Marginal Cost Marginal cost The change in a firm’s total cost from producing one more unit of a good or service. Explain and illustrate the relationship between marginal cost and average total cost. 10.4 LEARNING OBJECTIVE

19. 19 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs The Relationship between Short-Run Production and Short-Run Cost Why Are the Marginal and Average Cost Curves U Shaped? FIGURE 10-4 Jill Johnson’s Marginal Cost and Average Total Cost of Producing Pizzas We can use the information in the table to calculate Jill’s marginal cost and average total cost of producing pizzas. For the first two workers hired, the marginal product of labor is increasing. This increase causes the marginal cost of production to fall. For the last four workers hired, the marginal product of labor is falling. This causes the marginal cost of production to increase. Therefore, the marginal cost curve falls and then rises—that is, has a U shape—because the marginal product of labor rises and then falls. As long as marginal cost is below average total cost, average total cost will be falling. When marginal cost is above average total cost, average total cost will be rising. The relationship between marginal cost and average total cost explains why the average total cost curve also has a U shape. Explain and illustrate the relationship between marginal cost and average total cost. 10.4 LEARNING OBJECTIVE

20. 20 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs Solved Problem 10-4 The Relationship between Marginal Cost and Average Cost When marginal cost is greater than average total cost, marginal cost must be increasing. Explain and illustrate the relationship between marginal cost and average total cost. 10.4 LEARNING OBJECTIVE

21. 21 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs Graphing Cost Curves Average fixed cost Fixed cost divided by the quantity of output produced. Average variable cost Variable cost divided by the quantity of output produced. ATC = AFC + AVC Average fixed cost = AFC = Average variable cost = AVC = Average total cost = ATC = Graph average total cost, average variable cost, average fixed cost, and marginal cost. 10.5 LEARNING OBJECTIVE

22. 22 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs FIGURE 10-5 Costs at Jill Johnson’s Restaurant Graphing Cost Curves Jill’s costs of making pizzas are shown in the table and plotted in the graph. Notice three important facts about the graph: (1) The marginal cost (MC), average total cost (ATC), and average variable cost (AVC) curves are all U-shaped, and the marginal cost curve intersects both the average variable cost curve and average total cost curve at their minimum points. (2) As output increases, average fixed cost (AFC) gets smaller and smaller. (3) As output increases, the difference between average total cost and average variable cost decreases. Graph average total cost, average variable cost, average fixed cost, and marginal cost. 10.5 LEARNING OBJECTIVE

23. 23 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs Graphing Cost Curves 1.The marginal cost (MC), average total cost (ATC), and average variable cost (AVC) curves are all U-shaped, and the marginal cost curve intersects the average variable cost and average total cost curves at their minimum points. When marginal cost is less than either average variable cost or average total cost, it causes them to decrease. When marginal cost is above average variable cost or average total cost, it causes them to increase. Therefore, when marginal cost equals average variable cost or average total cost, they must be at their minimum points. 2.As output increases, average fixed cost gets smaller and smaller. This happens because in calculating average fixed cost, we are dividing something that gets larger and larger—output—into something that remains constant—fixed cost. Firms often refer to this process of lowering average fixed cost by selling more output as “spreading the overhead” (where “overhead” refers to fixed costs). 3.As output increases, the difference between average total cost and average variable cost decreases. This happens because the difference between average total cost and average variable cost is average fixed cost, which gets smaller as output increases. Understand the following three key facts about Figure 10-5: Graph average total cost, average variable cost, average fixed cost, and marginal cost. 10.5 LEARNING OBJECTIVE

24. 24 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs Costs in the Long Run Long-run average cost curve A curve showing the lowest cost at which a firm is able to produce a given quantity of output in the long run, when no inputs are fixed. Economies of scale The situation when a firm’s long-run average costs fall as it increases output. Economies of Scale Understand how firms use the long-run average cost curve in their planning. 10.6 LEARNING OBJECTIVE

25. 25 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs Costs in the Long Run Long-Run Average Total Cost Curves for Bookstores Constant returns to scale The situation when a firm’s long-run average costs remain unchanged as it increases output. Minimum efficient scale The level of output at which all economies of scale are exhausted. Diseconomies of scale The situation when a firm’s long-run average costs rise as the firm increases output. Understand how firms use the long-run average cost curve in their planning. 10.6 LEARNING OBJECTIVE

26. 26 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs Costs in the Long Run FIGURE 10-6 The Relationship between Short- Run Average Cost and Long-Run Average Cost Economies of Scale If a small bookstore expects to sell only 1,000 books per month, then it will be able to sell that quantity of books at the lowest average cost of $22 per book if it builds the small store represented by the ATC curve on the left of the figure. A larger bookstore will be able to sell 20,000 books per month at a lower cost of $18 per book. A bookstore selling 20,000 books per month and a bookstore selling 40,000 books per month will experience constant returns to scale and have the same average cost. A bookstore selling 20,000 books per month will have reached minimum efficient scale. Very large bookstores will experience diseconomies of scale, and their average costs will rise as sales increase beyond 40,000 books per month. Understand how firms use the long-run average cost curve in their planning. 10.6 LEARNING OBJECTIVE

27. 27 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs Solved Problem 10-6 Using Long-Run Average Cost Curves to Understand Business Strategy Both firms will still be short of minimum efficient scale after the trade, although their average costs will have fallen. Understand how firms use the long-run average cost curve in their planning. 10.6 LEARNING OBJECTIVE

28. 28 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs TERMDEFINITION SYMBOLS AND EQUATIONS Total costThe cost of all the inputs used by a firm, or fixed cost plus variable cost TC Fixed costsCosts that remain constant when a firm’s level of output changes FC Variable costsCosts that change when the firm’s level of output changes VC Marginal costIncrease in total cost resulting from producing another unit of output Average total costTotal cost divided by the quantity of output produced Average fixed costFixed cost divided by the quantity of output produced Average variable costVariable cost divided by the quantity of output produced Implicit costA nonmonetary opportunity cost― Explicit costA cost that involves spending money― Table 10-4 A Summary of Definitions of Cost Conclusion

29. 29 of 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 10: Technology, Production, and Costs AN INSIDE LOOK Sony Gambles on the Future Cost of the Next Generation of TVs >> Economies of scale will result in a lower average total cost of production in 2013 if Sony can sell 2.8 million OLED TVs.